Chapter 4Life Cycle Costing
Answer 1
Target costing
Traditional approach
The traditional approach to product costing, which is dominated by standard costing, is first to develop aproduct. An expected standard cost is then determined and a selling price (probably based on cost) isset, with a resulting profit or loss.
Costs are controlled at monthly intervals through variance analysis. The standard cost, once set, is onlyrevised for changes of a permanent or reasonably long-term nature.
Target costing approach
This is to develop a product concept and then determine the price that customers would be willing topay for it. A desired profit margin is then deducted from the price to leave a figure representing totalcost. This is the target cost.
If the target cost is vastly different from the cost at which the product can be produced, the product mayneed to be redesignedor may even be scrapped if the target is impossible to achieve.
Management may decide to go ahead and manufacture a product with a target cost well below thecurrently attainable cost. In such circumstances they will set benchmarks for improvement towards thetarget cost, by specified dates. Reducing the number of components, cutting out non-value-addedactivities and so on are possible cost reduction approaches.
Once the product goes into production, the target cost will gradually be reduced, the reductions beingincorporated into the budgeting process.
Target costing and cost reduction opportunities
To remain competitive, organisations must continually redesign their products. Far more so than in thepast, when cost reduction during the production process was important, a product's planning,development and design stages are therefore critical to an organisation's cost reduction process. Targetcosting, by focusing on costs incurred at all steps of a product's life (not just the production stage), givesadded emphasis to cost reduction at this vital stage.
Life cycle costing
Traditional approach
Traditional management accounting practice is, in general, to report costs at the physical production stage ofthe life cycle of a product; cost are not accumulated over the entire life cycle. This means a product'sprofitability is not assessed over its entire life but rather on a periodic basis. Costs tend to be accumulatedaccording to function; research, design, development and customer service costs incurred on all productsduring a period are totalled and are recorded as a period expense, effectively hiding them from cost reductionopportunities.
Life cycle approach
Using life cycle costing, however, such costs are traced to individual products over complete life cycles(from the product's inception to its decline). This overview of a product's profitability is of utmostimportance when assessing cost reduction opportunities.
Life cycle costing and cost reduction
One of the principal ideas of life cycle costing is that the profit generated by a product must cover notonly production costs, but the costs associated with the pre- and post-production stages (such as costsof research, design and testing, and costs of distribution and customer service). It has been claimed thatup to 90% of a product's life cycle costs will be determined 'up front' by decisions made very earlywithin the life cycle (production costs are based on design decisions, for example). The application of lifecycle costing will therefore ensure that cost control and cost reduction will be carried out at the earlystages, as well as during the production stage.
Answer 2
1 The budgeted life-cycle operating income for the new watch MX3 is€1,852,500 as shown below.
2 / Budgeted product life cycle costs for R&D and design / €1,000,000Total budgeted product life cycle costs / €13,647,500
Percentage of budgeted product life cycle costs incurred till the R&D and design stages /
3An analysis reveals that 80% of the total product life-cycle costs of the newwatch will be locked in at the end of the R&D and design stages when only7.33% of the costs are incurred (requirement 2). The implication is that itwill be difficult to alter or reduce the costs of MX3 once Saturniens finalisesthe design of MX3. To reduce and manage total costs, Saturniens must act tomodify the design before costs get locked in.
4The budgeted life-cycle operating income for MX3 if Saturniens reduces itsprice by €3 is €1,251,000 as shown below. This is less than the operatingincome of €1,852,500 calculated in requirement 1. Therefore, Saturniensshould not reduce MX3's price by €3.
Answer 3
(a)
Lifecycle costing is a concept which traces all costs to a product over its complete lifecycle, from design through to cessation.It recognises that for many products there are significant costs to be incurred in the early stages of its lifecycle. This is probablyvery true for Wargrin Limited. The design and development of software is a long and complicated process and it is likely thatthe costs involved would be very significant.
The profitability of a product can then be assessed taking all costs into consideration.
It is also likely that adopting lifecycle costing would improve decision-making and cost control. The early development costswould have to be seen in the context of the expected trading results, therefore preventing a serious over spend at this stageor under pricing at the launch point.
(b)
Budgeted results for game
On the face of it the game will generate profits in each of its three years of life. Games only have a short lifecycle as the gameplayers are likely to become bored of the game and move on to something new.
The pattern of sales follows a classic product lifecycle with poor levels of sales towards the end of the life of the game.
The Stealth product has generated $320,000 of profit over its three year life measured on a traditional basis. This represents40% of turnover – ahead of its target. Indeed it shows a positive net profit in each of its years on existence.
The contribution level is steady at around 83% indicating reasonable control and reliability of the production processes. Thisfigure is better than the stated target.
Considering traditional performance management concepts, Wargrin Limited is likely to be relatively happy with the game’sperformance.
However, the initial design and development costs were incurred and were significant at $300,000 and are ignored in theannual profit calculations. Taking these into consideration, the game only just broke even, making a small $20,000 profit.Whether this is enough is debatable, it represents only 2·4% of sales for example. In order to properly assess the performanceof a product the whole lifecycle needs to be considered.
Workings
W1 Split of variable and fixed cost for Stealth
Variable cost per unit = $20,000/4,000 unit = $5 per unit
Total cost = fixed cost + variable cost
$150,000 = fixed cost + (14,000 x $5)
$150,000 = fixed cost +$70,000
Fixed cost = $80,000 (and $120,000 if volume exceeds 15,000 units in a year.)
(c)
Incremental budgeting is a process whereby this year’s budget is set by reference to last year’s actual results after anadjustment for inflation and other incremental factors. It is commonly used because:
(1)It is quick to do and a relatively simple process.
(2)The information is readily available, so very limited quantitative analysis is needed.
(3)It is appropriate in some circumstances. For example, in a stable business, the amount of stationery spent in one yearis unlikely to be significantly different in the next year, so taking the actual spend in year one and adding a little forinflation should be a reasonable target for the spend in the next year.
There are problems involved with incremental budgeting:
(1)It builds on wasteful spending. If the actual figures for this year include overspends caused by some form of error thenthe budget for the next year would potentially include this overspend again.
(2)It encourages organisations to spend up to the maximum allowed in the knowledge that if they don’t do this then theywill not have as much to spend in the following year’s budget.
(3)Assessing the amount of the increment can be difficult.
(4)It is not appropriate in a rapidly changing business.
(5)Can ignore the true (activity based) drivers of a cost leading to poor budgeting.
(d)
Design and development costs: Setting a standard cost for this classification of cost would be very difficult. Presumably eachgame would be different and present the program writers with different challenges and hence take a varying amount of time.
Variable production cost: A game will be produced on a CD or DVD in a fairly standard format. Each CD/DVD will be identicaland as a result setting a standard cost would be possible. Allowance might need to be made for waste or faulty CDs produced.Some machine time will be likely and again this should be the same for all items and therefore setting a standard would bevalid.
Fixed production cost: The standard fixed production cost of a game will be the product of the time taken to produce thegame and the standard fixed overhead absorption rate for the business. This brings into question whether this is ‘meaningful’.Allocating fixed costs to products in a standard way may not provide meaningful data. It can sometimes imply a variability(cost per unit) that is not the case and can therefore confuse non-accountants, causing poor decisions. The time per unit willbe fairly standard.
Marketing costs: Games may have different target audiences and therefore require different marketing strategies. As suchsetting a standard may be difficult to do. It may be possible to set standards for each marketing media chosen. For examplethe rates for a page advert in a magazine could be set as a standard.
Answer 4
(a)
Life cycle costs are the costs incurred on products and services from their design stage, throughdevelopment to market launch, production and sales, and their eventual withdrawal from themarket. A product's life cycle costs might therefore be classified as follows.
(1)Acquisition costs (costs of research, design, testing, production and construction)
(2)Product distribution costs (transportation and handling)
(3)Maintenance costs (customer service, field maintenance and 'in-factory' maintenance)
(4)Operation costs (the costs incurred in operations, such as energy costs, and various facilityand other utility costs)
(5)Training costs (operator and maintenance training)
(6)Inventory costs (the cost of holding spare parts, warehousing and so on)
(7)Technical data costs (cost of purchasing any technical data)
(8)Retirement and disposal costs (costs occurring at the end of the product's life)
Life cycle costing versus traditional management accounting systems
Traditional management accounting practice
This is, in general, to report costs at the physical production stage of the life cycle of a product;costs are not accumulated over the entire life cycle. Such practice does not, therefore, assess aproduct's profitability over its entire life but rather on a periodic basis. Costs tend to beaccumulated according to function; research, design, development and customer service costsincurred on all products during a period are totalled and recorded as a period expense.
Life cycle costing
(1)Using life cycle costing, on the other hand, such costs are traced to individual productsover complete life cycles. These accumulated costs are compared with the revenuesattributable to each product and hence the total profitability of any given product can bedetermined. Moreover, by gathering costs for each product, the relationship between thechoice of design adopted and the resulting marketing and production costs becomes clear.
(2)The control function of life cycle costing lies in the comparison of actual and budgeted lifecycle costs for a product. Such comparisons allow for the refinement of future decisionsabout product design, lead to more effective resource allocation and show whether expectedsavings from using new production methods or technology have been realised.
Life cycle costing and AMT environments
Research has shown that, for organisations operating within an advanced manufacturingtechnology environment, approximately 90% of a product's life-cycle cost is determined bydecisions made early within the life cycle. In such an environment there is therefore a need toensure that the tightest cost controls are at the design stage, because the majority of costs arecommitted at this point. This necessitates the need for a management accounting system thatassists in the planning and control of a product's life cycle costs, which monitors spending andcommitments to spend during the early stages of a product's life cycle and which recognises thereduced life cycle and the subsequent challenge to profitability of products produced in an AMTenvironment. Life cycle costing is such a system.
Summary
Life cycle costing increases the visibility of costs such as those associated with research, design,development and customer service, and also enables individual product profitability to be morefully understood by attributing all costs to products. As a consequence, more accurate feedbackinformation is available on the organisation's success or failure in developing new products. Intoday's competitive environment, where the ability to produce new and updated versions ofproducts is of paramount importance to the survival of the organisation, this information is vital.
(b)
Lifecycle costs
$000R&D (850 + 90) / 940
Production
Variable (750 + 2,500 + 1,875) / 5,125
Fixed (500 x 3) / 1,500
Marketing
Variable (125 + 400 + 225) / 750
Fixed (300 + 200 + 200) / 700
Distribution
Variable (25 + 100 + 75) / 200
Fixed (190 x 3) / 570
Customer service (75 + 200 + 150) / 425
Total life cycle costs / 10,210
Production (000 units) (25 + 100 + 75) / ÷200
Cost per unit / $51.05
The suggested price will be therefore provide a profit over the complete lifecycle.
Answer 5
(a)
Maturity Stage / Total / Decline stageMonths / 31 – 70 / 71 – 110
Number of unit produced and sold (W1) / 20,000 / 20,000 / 20,000
Selling price per unit ($) / 60 / 60 / 40
Unit variable cost ($) / 30 / 25 / 30
Unit contribution ($) / 30 / 35 / 10
Total contribution / 600,000 / 700,000 / 1,300,000 / 200,000
Cash flow brought down / (25,000) / 1,275,000
Cash flow carried down / 1,275,000 / 1,475,000
W1
Months 31 – 70: 1,000 units per month x 40 months = 40,000 units
Months 71 – 110 are calculated as follows:
(10 x 800) + (10 x 600) + (10 x 400) + (10 x 200) = 20,000 units
The clue to knowing which sales demand applies to which life cycle stage is to look at the sales demand over the life cycle. Monthly sales levels continue to increase up to months 31 – 70. Thereafter they decline. The growth stage typically shows a rapid increase in sales and the maturity stage shows a slow down in sales growth. However, it is only at the decline stage that sales actually decline.
(b)
The possible reasons for the changes in cost and selling prices during the life cycle of the product. There are four stages in a product life cycle. Each stage has different features in relation to costs and sales. These are:
Introductory stage
The principal aim during this stage is to introduce a product and build demand. The organization is likely to spend significant amounts on advertising and distribution to get the product or service known. Production costs, i.e. unit variable costs are also likely to be high as the product has not yet achieved economies of scale. This is also the time in the product lifecycle where research and development costs are incurred. Prices are generally high if a market skimming policy is adopted to take advantage of being an early entrant to the market and so recoup costs. However an organization may choose a market penetration strategy so prices are low to gain market share. For W, costs are high at $50/unit and the selling price is also high at $100/unit. An unit contribution of $50/unit sold is the highest contribution over the product life cycle. W therefore appears to be seeking to recoup as much R&D expenditure and fixed asset expenditure as possible at this stage.
Growth stage
The aim during this stage is to build market share. Costs will still be high as more promotion is needed to advertise the product more widely. Distribution channels may be expanded to take up more market share. The price will be high but may need to fall if demand is seen as falling. W charges between $70 and $80/unit sold and the price drops over the period in response to market conditions. However, the unit variable cost is also falling. Margins are falling but volume has risen so the product is contributing more at this stage than the last one.
Maturity stage
This is the most profitable stage of the product’s life cycle. Costs will begin to fall as economies of production are achieved. Advertising costs should fall as product awareness is stronger. Marketing is concentrated in reaching new customers. The price will fall in response to competition and to retain market share. Profitability is shown by the contribution of $1.3 million that is the highest over the life cycle of the product despite a fall in selling price/unit. This is achieved by volume sales as well as the unit cost continuing to fall.
Decline stage
This is the stage at which the product is losing popularity and market share is falling. W can adopt a choice of strategies including running the product down or discontinuing it. Costs fall as marketing support is withdrawn but economies of scale begin to decline so the unit variable cost actually rises again to $30/unit. Prices are reduced to mop up market share.
A4-1